The following invention relates to a method and system for managing risk and, in particular, to a method and system for managing the risk associated with commodities and other complex financial exposures.
Business enterprises seek to accurately predict the costs of raw materials and revenues in order to monitor and manage their cash flows. For businesses that consume or produce commodities, this is a difficult task because the spot prices of commodities often change rapidly and unpredictably. For example, a manufacturer of aluminum requires a certain amount of electricity over a certain period of time, called the “budget period,” to operate its manufacturing equipment to meet its aluminum production commitments during the budget period. In addition, the manufacturer also needs to know the price of the electricity required for manufacturing in order to determine its total costs for producing the aluminum. Furthermore, the manufacturer also desires to determine the value of the aluminum produced so that it can guarantee its value. Similarly, the electricity provider must determine whether it can meet the manufacturer's electricity demands, at what price and for what period of time. The electricity provider may base this determination on its cost to generate the electricity, its total obligations to provide electricity (i.e., its load) and various environmental and market factors. Because there are numerous factors that can affect the price and availability of electricity and aluminum, such as changes in demand, the weather and government regulations, both the electricity provider and the aluminum producer desire access to a predictable price for the electricity and the aluminum.
In the case of a power producer, such as an electricity provider, the production of power entails several risks. For example, power producers commonly use power production plants that are designed to be switched on and off daily, as necessary. This allows the producer to be able to operate the plant during peak periods when prices are high enough to cover variable costs, (for example, the commodity cost of fuel), while avoiding this cost by switching the plant off when prices are too low to cover such costs. For power production plants having high operating costs, this can lead to more extreme fluctuations in revenues than for other commodity producers when fuel costs and electric prices trend up or down for any extended period, as is often the case.
There are three primary strategies for dealing with the risks associated with producing, supplying and consuming commodities. In a first strategy, the producer or consumer uses equity to finance fluctuations in the cost of the particular commodity. Because equity, unlike debt, does not guarantee a regular return, the commodity price movements are absorbed by variations in any returns on the equity. Alternatively, the producer/consumer may set aside cash reserves for riding out any dips or spikes in commodity prices. The obvious drawback to this strategy is that the power provider does not have the benefit of a consistent revenue stream and the power consumer does not have a predictable cost structure. Furthermore, unused cash reserves or high equity levels are costly because the cash is not generating much income and equity carries a higher rate of return than debt.
In a second strategy, the commodity consumer or producer enters into forward contracts in which the delivery of the commodity at a future date is guaranteed at a set price. Typically, commodity producers and consumers do not enter into forward contracts directly because generally each have different objectives with respect to price, term and structure of such contracts. As a result, the commodity will either pass through a financial middleman or pass directly between the commodity producer and consumer at an index-based price so that a financial or derivative contract can be used to achieve the desired financial guarantees. Thus, by way of example, a power provider may sell the right to take the output of its power plant to a financial intermediary for a stream of fixed payments thereby locking in a return for an extended period of time. In this case, the intermediary may execute a dynamic hedging strategy involving an initial forward sale of power and purchase of fuel followed by regular additional sales or purchases of both fuel and electricity as market prices change. The hedging strategy is designed to lock in the plant return for a margin, or risk premium, above the price paid to the power provider. The risk premium is intended to compensate the intermediary for the risk that the hedging strategy may not work (strategy risk) or that the strategy may not be able to be implemented at the prices expected (execution risk). This second strategy results in disadvantages for the power provider in that the power provider has given up the risk premium and may also be contractually exposed to changes in his operating costs or plant availability.
A third common strategy involves the commodity consumer or provider assuming the role of financial intermediary and stabilizing its revenue stream using derivative products or forward contracts. In this case, the power provider models its portfolio, that includes power generating assets as well as loads and sales obligations, using forward contracts and option contracts according to well-known techniques. Based on the model portfolio, the power provider then hedges its portfolio by purchasing or selling power or raw materials through forward and option contracts using well-known techniques. If the model portfolio is accurate (strategy risk) and the hedge is purchased efficiently (execution risk), the power provider would achieve a stable and predictable revenue stream for its power.
There are also numerous disadvantages to managing commodity risks with this third strategy. First, for the power provider to achieve revenue stability using the modeling and hedging approach requires that the power provider have significant financial expertise. Furthermore, the power provider would have to continuously monitor changing market conditions and update the model portfolio and hedges accordingly. Also, in many instances, the power provider does not have the power interchange agreements in place with counterparties in order to execute the necessary hedges in a cost-effective way. Because power providers, as well as other entities that require stable access to a particular commodity, typically do not have the expertise and relationships to model and hedge their commodity positions, such an approach is often not available.
In summary, the prior art hedging technology does not enable a commodity consumer or producer to easily tailor exactly the amount of strategy risk and execution risk that is retained or laid off. Using the second strategy above, almost all the risk is laid off while in the third strategy most of the strategy and execution risk is kept. Accordingly, it is desirable to provide a method and system in which an entity may better manage its risks associated with its position in a particular commodity.